The Case for Middle Market High-Yield Investing

Global Fixed Income Insights

The Case for Middle Market High-Yield Investing

Like many sectors of the global fixed income markets, high-yield bonds have generated strong returns for investors in recent years.1 With the risk of additional rate hikes, however, investors are searching for the best place to be in the bond market. We believe the answer is high-yield now more than ever, and within that, middle market issuers.

Although U.S. high-yield bonds feel the impact of rising rates like other higher-quality bonds, the impact is usually significantly lower. When the Federal Reserve hikes rates, it's the lower-quality bonds that tend to perform better, albeit with greater risks, largely because they generally have less duration and are more influenced by the equity markets.

We feel that high-yield bonds remain one of the most appealing investment options available in fixed income, and that an actively managed portfolio of high-yield bonds can be a sensible part of a client's overall portfolio. Although yields tightened significantly in 2017, we expect continued risk on sentiment and the global backdrop to support moderate spread compression. Additionally, we expect default rates to continue to decline as reduced stress in the commodity sectors has led to a decline in overall default volume and issuers have few near-term liquidity pressures.

In particular, we believe that a high-yield portfolio focused on middle market issuers can potentially offer investors an attractive means of accessing high yields due to certain characteristics of these borrowers. This belief is based on our proprietary research that demonstrates middle market high-yield bonds can offer a significant yield advantage relative to the broader high-yield market, have less sensitivity to interest rates and demonstrate lower volatility than larger issuers, as seen in Display 1.

This paper explores these points in more detail to better understand the potential benefits and some of the risks to investing in middle market high-yield bonds.

Past performance is not indicative of future results. Provided for informational purposes only and is not intended to predict or represent the performance of any Morgan Stanley investment or strategy. See below for definitions.

Source: MSIM. Bloomberg Barclays. As at June 30, 2018.

Asset Class Overview
The high-yield market is well over $1 trillion in size and consists of corporate bonds rated BB+ and below by the major credit rating agencies.2 In return for their increased credit risk, high-yield bonds typically offer higher yields than U.S. Treasury bonds and investment-grade corporate bonds. As evidenced by its size, the high-yield market is a mature sector of the fixed income markets and has developed significantly since its start in the 1980s.

Typically, the high-yield market has financed both fallen angels, meaning credits that have lost their investmentgrade ratings, or more growth-oriented companies that require large amounts of capital to help fund their expansion. A good example of this is the build-out of wireless cell phone networks in the 1980s and early 1990s, as well as local casinos and cable television. In exchange for the more speculative nature of these credits and industries, investors typically received shorter maturities and bigger coupons than larger investment-grade credits. Additionally, investors have typically maintained a structurally senior position in the capital structure (e.g., liens on assets) and have had more of a voice in what the issuer can and cannot do in the form of covenants. These typically will limit how much debt the issuer can assume, and cap the amount of fixed charge liabilities3 and dividends they can offer. Typical for this asset class, the majority of new issue high-yield bonds are also callable at a premium, usually at half of their coupon (a new issue 10-year bond is typically callable in five years).4 This helps limit the interest rate risk of these securities, giving high-yield bonds one of the lowest durations of any part of the fixed income market.

State of the Market: High-Yield Bonds in Rising Rates
A combination of gradual tightening of monetary policy, the threat of escalating trade wars, equity volatility and a pickup in idiosyncratic news flow has left investors looking for the best way to position their portfolios. However, investors may find it in an unlikely place: high yield. And within the high-yield market, it's the bonds on the lowest rung of the rating ladder—the B and CCC names—that tend to perform the best in a rising rate environment.

While high-yield bonds feel the impact of rising rates like other high-quality bonds, the impact tends to be less dramatic. That is in large part due to the fact that high-yield companies generally have shorter maturities than their high-quality competitors. Additionally, many high-yield bonds have the ability to be called at a premium, which helps provide high-yield bonds with some of the lowest durations found in the fixed income market. For example, the duration of the Bloomberg Barclays U.S. Corporate High-Yield Index is 3.94 years, compared with 7.17 years for the Bloomberg Barclays Investment-Grade Corporate Index.5 With rate hikes likely to continue in 2018 and into 2019, we tend to believe that middle market credits and the B and CCC segments of the market are most appealing as they tend to have even less duration than the broader high-yield market and will likely be the most sensitive to the new pro-growth agenda.

DISPLAY 2: Size of the high-yield middle market

Source: Bloomberg Barclays, MSIM. Data as of June 30, 2018.

Middle Market—What Is It?
As we sit near all-time lows in yield for global high-yield indexes, and face potential rake hikes, an interesting and often overlooked way to approach high-yield investing is to focus on middle market credits. There are various ways to define the middle market portion of the U.S. high-yield universe. Revenue, EBITDA and enterprise value6 are all valid metrics, but we find total outstanding debt to be the most appropriate gauge. Our definition has evolved over the years, but the characteristics have not. For the purposes of this paper, we define the middle market as companies with $150 million to $1 billion of total bonds outstanding. We believe that by using a disciplined and diversified approach, investing in this segment can potentially provide investors with increased yields with limited volatility throughout market cycles and less duration risk than the broader high-yield market.

Currently, middle market companies can typically offer a 100 to 150 basis points (bps) yield advantage over larger companies with similar ratings and credit statistics, which, in our opinion, is not due to their bonds being inherently more risky, but rather because of their size and market participants' regard for them.7 It is important to note that middle market companies are smaller credits, not necessarily worse credits. The yield advantage is largely a function of this market segment being overlooked by larger market participants. Though generally assumed to be less liquid, as shown in Display 2, as of June 30, 2018, these issuers made up 66 percent of the U.S. high-yield market in terms of their sheer number and a quarter percent based on par amount outstanding.

Why We Think the Middle Market Is Attractive
Given the relatively small middle market issuance size, large asset managers generally tend to exclude middle market names from their focus lists because they are unable to buy enough of them to satisfy their internal portfolio allocation requirements. Furthermore, brokers and investment houses tend to overlook these issues because their larger client bases do not actively trade them.

On the primary issuance side, large dealers who underwrite bonds focus less on these issuers because they come to market much less often than bigger companies with larger and more complex capital structures. Additionally, since middle market companies issue new bonds much less frequently than larger named companies, rating agencies tend to be less focused on them. Their ratings, therefore, are often not reflective of their most recent credit profiles compared to their larger peers. In the absence of upto- date information, rigorous bottom-up research can help uncover opportunities in any mis-rated securities.

As noted earlier, middle market issuers have typically offered a yield advantage of 100 to 150 bps versus larger high-yield borrowers, in large part because they receive less scrutiny from market participants including credit rating agencies, underwriters and asset managers. We believe one of the most attractive features of middle market bonds is derived from an investment manager's ability to use diligent fundamental research to identify issuers with the strongest credit metrics and then look to benefit from the additional yield they can provide.

Increased Dialogue With Management, Not With Investor Relations
Middle market companies also provide some advantages with respect to the research process. Credit research analysts can often speak directly with a company's chief executive officer or chief financial officer at least on a quarterly basis. This direct dialogue helps in the credit evaluation process and leads to a better understanding of management's focus on their business plan. This dynamic is much less common in larger cap issuers, as they are far more likely to have investor relations teams, who often tend to be more focused on their equity holders rather than bondholders. Management at middle market companies is usually interested in knowing who their bondholders are, and also engage in ongoing dialogue with them.

Structural Simplicity
Capital structures of middle market issuers tend to be simple and easy to analyze as they typically have a single tranche of bank debt and one or two tranches of bonds. Additionally, when a middle market company brings out a new issue, investors can often demand greater protections be placed in the structure, security and covenants of the new issue because of the issuer's relatively unknown quality in the overall marketplace. This can lead to increased secured bond issuance, preferable to the typical senior unsecured bond that is common in the high-yield market.

The opposite is true when you look at some of the larger issuers. The largest capital structures in the high-yield market are often an intricate web of entities that are interconnected in complicated ways. It is not uncommon to see a company move its assets from one legal entity to another internal entity, which may not guarantee the bonds that were originally issued. Assets can also be transferred to foreign subsidiaries, or dropped into a tax-advantaged structure like a master limited partnership or real estate investment trust. Inter-company loans to finance-related entities can be put in place, often at the expense of bondholders. Additionally, holding company issuance has been increasing, which are usually highly levered transactions that offer little or no asset coverage to investors. These structures can present opportunities for investors, but, given their structural complexity, they often require more legal astuteness than fundamental credit research can provide.

It is important to note, however, that the relative structural simplicity of middle market high-yield bonds is not a defense against their defaults, and that intensive fundamental research is still needed. For example, in 2013, a middle market issuer with a single senior secured bond and a small unsecured convertible bond defaulted on its bonds as a result of the closure of one of its key facilities in response to unexpected regulatory actions. The closed facility was instrumental to the issuer's overall operations and underscores one of the downsides to investing in smaller companies, as they may have limited operations compared to larger companies. This example helps demonstrate the need for diligent and thorough research to fully understand the credit quality and potential risks of middle market issuers.

Avoiding Volatility
A key feature that makes middle market high-yield bonds attractive is their historically lower level of volatility as compared to the larger high-yield issuers. Display 3 compares the price volatility of middle market issuers to that of larger high-yield issuers. As there is no index of middle market credits, we have partitioned the Bloomberg Barclays U.S. Corporate High-Yield Index into two buckets, one with issuers with less than $1 billion in bonds outstanding and one with issuers with bonds equal to and greater than $1 billion. As the chart shows, volatility has been lower for the smaller middle market issuers in the Index. This is generally true, but even more so in times of market stress, like the financial crisis in 2008 and 2009, when volatility spiked dramatically. This differential becomes more pronounced in times of market distress and, at times, may exceed twice the level of the broader high yield market.

We define "middle market" as companies with $150 million to $1 billion in total bonds outstanding at the time of investment.

Before 2001, the total number of unique large-market tickers compared to the total number of unique tickers in the index was very low. Due to sample size, we chose to start at December 31, 2000. Price volatility shown in annualized rolling three month daily price volume.

Past performance is not indicative of future results. The index performance is provided for informational purposes only and is not intended to predict or represent the performance of any Morgan Stanley investment or strategy.

When markets experience periods of stress, as in 2008, investors often want to reduce holdings of risky assets such as equities or high-yield bonds and move to safer, more liquid alternatives such as cash. High-yield funds and high-yield exchange-traded funds may experience significant redemption requests, requiring managers to liquidate holdings. These funds will typically sell their largest bonds, as they are often the most liquid holdings. Investment managers also know that they will most likely be able to buy back these positions should they want to reinvest in these issues. This can lead to undesirable excess volatility and underperformance in their portfolios. In contrast, middle market bonds tend to trade more on their intrinsic fundamentals rather than on broader market technicals, like interest rate volatility or fund/ capital flows.

Sharpe ratios, a measure of excess returns per unit of risk, are considerably higher in the middle market, while beta—a commonly used volatility metric—is noticeably lower, implying lower risk, as shown in Display 1.

Conclusion
In our experience, there are a number of reasons to consider investing in the high-yield middle market. These reasons become more pronounced when rates are rising, as they now are. Their demonstrated decreased volatility in the past is a key feature to consider, along with their associated capital structures, which tend to be relatively simple to analyze. The ability to be called at a premium, one of the common features for many, new issue high-yield bonds, helps provide these bonds with some of the lowest durations found in the fixed income market. Finally, middle market companies, with their more accessible management teams, may provide advantages to investors when analyzing their associated businesses.

For investors, fixed income investments have been a strong generator of positive returns for some time, and the U.S. high yield market is no exception.8 However, with rate hikes likely to continue in 2018, and potential policy changes from the Trump administration, investors are left wondering what to expect next. Our view is that default rates are likely to remain contained and that high-yield issuers are the best place to be within fixed income. Furthermore, based on our analysis, we believe that the middle market of the high-yield universe, specifically, can potentially provide that sweet spot for investors—a higher yield, less correlation to interest rates and lower volatility than larger issuers for those investors comfortable with the risks of investing in the high yield sector.

6 EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is a free cash flow metric. Enterprise value is a measure of a company’s value, often used as an alternative to straightforward market capitalization.

7 Source: MSIM. Data as of December 31, 2017.

8 Bloomberg Barclays U.S. Corporate High-Yield Index as of December 31, 2017.

Risk ConsiderationsThere is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the fund will decline and that the value of fund shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. Investing involves risks including the possible loss of principal.

Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest-rate environment, the portfolio may generate less income. High-yield securities (“junk bonds”) are lower rated securities that may have a higher degree of credit and liquidity risk. Asset-backed securities are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Public bank loans are subject to liquidity risk and the credit risks of lower rated securities. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Distressed and defaulted securities are speculative and involve substantial risks in addition to the risks of investing in junk bonds, including a higher risk of default. Preferred securities are sensitive to interest rate changes. Mezzanine investments are subordinated debt securities; thus they carry the risk that the issuer will not be able to meet its obligations and they may lose value. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries.

DEFINITIONS
Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation.

Interest rate risk is the risk that an investment’s value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

Callable indicates that a security contains an embedded call provision that allows the issuer to repurchase or redeem the security by a specified date.

Par amount outstanding is the total dollar value of bonds issued for a specific bond issue.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

The Sharpe ratio is calculated by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.

INDEX DEFINITIONSThe Bloomberg Barclays U.S. Corporate High Yield Index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below. The Index excludes emerging market debt.

The Bloomberg Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment grade, fixed-rate, taxable, corporate bond market.

The indices are unmanaged and it is not possible to invest directly in an index.

IMPORTANT DISCLOSURES
Past performance is no guarantee of future results.

The views, opinions, forecasts and estimates expressed are those of the author or the investment team as of date presented and are subject to change at any time due to market, economic or other conditions. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness.

This material is a general communication, which is not impartial, and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

DISTRIBUTION
This communication is only intended for and will be only distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the strategy’s/ product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.

Hong Kong: This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This document should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. Australia: This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.

Japan: For professional investors, this document is circulated or distributed for informational purposes only. For those who are not professional investors, this document is provided in relation to Morgan Stanley Investment Management (Japan) Co., Ltd. (“MSIMJ”)’s business with respect to discretionary investment management agreements (“IMA”) and investment advisory agreements (“IAA”). This is not for the purpose of a recommendation or solicitation of transactions or offers any particular financial instruments. Under an IMA, with respect to management of assets of a client, the client prescribes basic management policies in advance and commissions MSIMJ to make all investment decisions based on an analysis of the value, etc. of the securities, and MSIMJ accepts such commission. The client shall delegate to MSIMJ the authorities necessary for making investment. MSIMJ exercises the delegated authorities based on investment decisions of MSIMJ, and the client shall not make individual instructions. All investment profits and losses belong to the clients; principal is not guaranteed. Please consider the investment objectives and nature of risks before investing. As an investment advisory fee for an IAA or an IMA, the amount of assets subject to the contract multiplied by a certain rate (the upper limit is 2.16 percent per annum (including tax)) shall be incurred in proportion to the contract period. For some strategies, a contingency fee may be incurred in addition to the fee mentioned above. Indirect charges also may be incurred, such as brokerage commissions for incorporated securities. Since these charges and expenses are different depending on a contract and other factors, MSIMJ cannot present the rates, upper limits, etc. in advance. All clients should read the Documents Provided Prior to the Conclusion of a Contract carefully before executing an agreement. This document is disseminated in Japan by MSIMJ, Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: The Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association.

U.S.: A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2.

Please consider the investment objective, risks, charges and expenses of the fund carefully before investing. The prospectus contains this and other information about the fund. To obtain a prospectus, download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.

The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

MSIM has not authorised financial intermediaries to use and to distribute this document, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary.

This document may be translated into other languages. Where such a translation is made this English version remains definitive. If there are any discrepancies between the English version and any version of this document in another language, the English version shall prevail.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without MSIM’s express written consent.

All information contained herein is proprietary and is protected under copyright law.

It is important that users read the Terms of Use before proceeding as it explains certain legal and regulatory restrictions applicable to the dissemination of information pertaining to Morgan Stanley Investment Management's investment products.

The services described on this website may not be available in all jurisdictions or to all persons. For further details, please see our Terms of Use.